The Scary Truth of Microfinance

Euan Lim

In recent times, microfinancing has taken the developing world by storm. It has granted marginalised, poorer communities the opportunity to have access to financial services. But what exactly is microfinancing, and why has it had such a big impact on Less Economically Developed Countries (LEDCs) and marginalised communities?

"Born” in Bangladesh in the 1970s, microfinancing is a new way of allowing small businesses and entrepreneurs to receive loans. In its current state, business loans are significantly more difficult to obtain, as compared to loans through microfinancing. While the criteria varies from country to country, business loans generally require a significant amount of documentation, as well as collateral, among other things. For small businesses, especially those in LEDCs, it can be extremely difficult to get business loans approved, due to the risk of defaulting on loan repayment. Hence, through microfinancing, small businesses are able to expand their businesses. Eventually, the goal of microfinancing is for these small businesses to no longer require these smaller loans, and to be large or successful enough to qualify for business loans.

While in theory, microfinancing sounds like a fantastic idea to help small business owners in LEDCs break out of the poverty cycle, there are obviously some drawbacks to it. One of the biggest and most well-known detriments of microfinance is over-indebtedness. It’s important to understand that microfinance institutions (MFIs), which provide microfinance loans, are at the end of the day, profit-driven businesses. To ensure that their business is profitable, MFIs often charge extremely high interest rates as compared to banks. The thing is, small business owners who require loans have no real choice in taking up these high interest loans, as they cannot qualify for business loans. Especially because businesses are more of long-term investments rather than short-term, it can be extremely difficult for these small business owners to turn a profit large enough to repay the loan within its given timeframe. This leads to many business owners having to take on many loans from different MFIs to ensure that they can pay their instalments on the loans. The gradual build-up of this debt can lead to over-indebtedness, where the already poor business owners end up sunken in debt to MFIs. As unfortunate as it is, this is not an uncommon occurrence. In 2010, there was the microfinance crisis in Andhra Pradesh, where 57 debtors committed suicide over the debt that they had incurred from microfinance.

This reveals to us a larger problem beneath the surface. While the microfinance system is in fact helpful for these business owners to get on their feet, it also shows that the banking systems in these countries that use microfinance (such as India and Bangladesh), have fundamentally failed. The fact that there needs to be a system like microfinance that poor communities have created such a significant reliance on, shows that the banking system does not cater to the larger population as a whole. It paints a jarring picture of what the poor and marginalised communities go through. They are constantly trapped in this vicious cycle of poverty, and the banks do not provide them with any concrete methods of doing so.

In conclusion, microfinance is an incredibly impactful section of developing economies. It gives the poor a lifeline and is actually a massive success story in the road to financial inclusion. However, as successful as it has been, it also begs the question of why it needs to exist in the first place, since microfinance demonstrates the overwhelming inadequacies in the banking systems in these countries. Nonetheless, it has been successful considering that it does help to resolve these inadequacies, improving the lives of many.

References

Finezza Blog. “7 Challenges Faced by Microfinance Institutions,” January 14, 2020. https://finezza.in/blog/7-challenges-faced-by-microfinance-institutions/.(Accessed April 29, 2022).

D’Angelo, Matt. “Microfinance: What It Is and Why It Matters.” Business News Daily, 2018. https://www.businessnewsdaily.com/4286-microfinance.html.(Accessed April 29, 2022).

Gallarati, Giorgia. “Andhra Pradesh Microfinance Crisis: What Went Wrong – Think Conference,” n.d. http://thinkiea.com/foreign-aid-and-development/andhra-pradesh-microfinance-crisis-what-went-wrong/. (Accessed April 29, 2022).

FINCA International. “What Is Microfinance?,” n.d. https://finca.org/our-work/microfinance/#:~:text=Microfinance%20refers%20to%20the%20financial (Accessed April 29, 2022).